April 26, 2017 Chicago | July 11, 2017 Boston | Nov. 9, 2017 San Francisco | The Women Adviser Summit is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.

'Madoff' audits will crimp broker-dealers

An SEC rule proposal intended to thwart the likes of Bernard Madoff likely would result in significantly higher compliance costs for smaller broker-dealers.

Last week, the Securities and Exchange Commission unanimously agreed to move forward with a rule change that, if enacted, would expand on regulations approved by the commission two years ago. Under the proposal, broker-dealers would have to file quarterly reports outlining whether they maintained custody of clients' assets and, if so, offer details about how they did it.

Broker-dealers holding assets in custody also would be subject to regular examinations by a public accounting firm to ensure they were complying with SEC rules pertaining to net-capital requirements, the segregation of customer and firm accounts, and routine reporting on the securities they held for themselves and their customers.

In addition, the B-Ds' internal controls also be would reviewed, much in the same way that auditing firms examine corporate financial controls as directed by Section 404 of the Sarbanes-Oxley Act of 2002.

“This brings a much more rigorous approach to making sure that custody management is honest, transparent and much safer for investors,” said Kurt Schacht, managing director of the CFA Institute. “This makes it much more difficult for the scoundrels in this business to do the damage we saw with Madoff.”

Broker-dealers that do not act as custodians would be required to submit to periodic reviews by an independent public accountant to verify their status.

PREVENTING FRAUD

The proposed rule change is in response to the massive Ponzi scheme carried out by Mr. Madoff, as well as the fraud allegations against R. Allen Stanford.

The new rules mainly would affect about 300 B-Ds that maintain custody of clients' assets. The vast majority of the 5,000 B-Ds registered with the SEC use outside custodians.

If enacted, the rule would require all B-Ds to allocate more time and money toward custody reporting. That could prove particularly burdensome for smaller firms that don't enjoy the same economies of scale as their bigger rivals.

Although his firm is in favor of the proposal, the cost of compliance is “certainly is going to go up 10% and as much as 25% for a small, self-clearing broker-dealer,” said Michael Hogan, chief executive of Foliofn Investments Inc. “It's not going to go up that much for Merrill Lynch.”

Foliofn hopes to keep the increase in its compliance costs below 10%, Mr. Hogan said. But it remains to be seen whether Foliofn, and other custodial firms, will pass those costs along to investment advisers who use them to hold clients' assets.

The reporting amendments will be open for public comment for 60 days. The quarterly reporting requirement would go into effect in December; the examination requirement would go into effect in September 2012.

COST CONCERNS

The Securities Industry and Financial Markets Association, which represents B-Ds, will file a comment letter asking the SEC to consider the issue of costs carefully, said Kevin Carroll, SIFMA managing director and associate general counsel.

“We are sensitive to the incremental cost burden of the proposed rule on our members, particularly our smaller broker-dealers,” Mr. Carroll said. “There are probably reasonable ways to narrow and focus the rules to alleviate some of that burden.”

The new rules are not directly mandated by the Dodd-Frank financial reform law, but they are intended to help the Public Company Accounting Oversight Board fulfill its Dodd-Frank requirement of overseeing accounting firms that audit broker-dealers.

Under the proposed rule, the SEC and a designated examining authority would be allowed to review the audits.

“The goal would be to enhance the commission's or the [designated examining authority's] examination of the broker-dealer by building on the work performed by the accounting firm, particularly in the area of verifying the custody of customer assets,” SEC Chairman Mary Schapiro said at a commission meeting June 15.

The rule would impose on B-Ds similar custodial guidelines as the ones imposed on investment advisers two years ago. Under those guidelines, investment advisers now are subject to surprise exams of client assets by independent public accountants.

Broker-dealers that maintain custody of the assets of an investment adviser's clients could satisfy the adviser custody requirements by fulfilling those contained in the broker-dealer reporting rule.

Commissioner Elise Walter said the move would ensure that SEC custody oversight extended to both players in the advice market — investment advisers and broker-dealers.

“I'm pleased to see we're rounding the loop,” Ms. Walter said.

In the wake of the Madoff and Stanford scandals, investors are more cognizant of the role of custodians.

“Advisers have certainly taken on more responsibility to communicate with their clients about the advantages of third-party custody,” said Greg Vigrass, president of custody at Folio Institutional.